A bellicose Vestager’s high-stakes game

Margrethe Vestager sent shockwaves through the business community in both the European Union and elsewhere with her bold announcement this week that Luxembourg and the Netherlands were under a duty to claw back previous tax breaks that they had given to Fiat and Starbucks respectively.

The sums of money involved were, for international transactions, relatively modest, amounting to between €20 million and €30 million in each case. But everyone understood that her statement was only the opening round of a large campaign that could easily impose substantial liability on such American giants as Apple and Amazon, who have actively sought out tax havens such as Ireland and Luxembourg for their corporate operations.

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The question is what one should make of this effort, and the answer, I believe, is a split verdict. The objectives are arguably laudable. Their achievement is a decidedly more difficult matter. One general proposition of economic theory is that there are two forms of government action that can distort competitive behavior. The first is taxes and tariffs. The second is subsidies, whether they be in cash or in kind. In an ideal world, it is wise to eliminate both these forms of distortion. But in an imperfect world compromises with first principles often have to be made, because it is typically more difficult to identify and eliminate disguised subsidies than it is to remove the various taxes and tariffs that can distort trade between nations.

Vestager is right to note that these disguised transfer payments constitute the kind of government subsidy that is prohibited under the EU.

A sound policy response, therefore, has to temper the enforcement bravado with institutional realism. Getting to a competitive market is not easy business. All too often, ambitious programs of enforcement can be counterproductive, for two simple reasons. First, they entail an enormous commitment of government and private resources. Second, they often make erroneous determinations that can undermine the force of the overall program.

These propositions apply to the thorny topic of transfer pricing, which lies at the heart of commissioner Vestager’s mission statement.

Most transactions in goods and services are between strangers. In these cases, each party seeks the best deal that it can get, so that the price of the exchange represents a market value under which neither side gives a subsidy to the other. The same cannot be said of cross border transactions between related parties. In these cases, the price chosen for a particular transaction could be set either above or below the market price for reasons that have nothing to do with efficiency of market exchanges. Instead, with the same party on both sides of the transaction, it is tempting for the two firms to collude — a consciously nasty word — on the price, in order to reduce their combined obligations to some third party.

This often happens when one of the two related corporations does business in a high-tax jurisdiction and the other does business in a low-tax jurisdiction. Thus, it makes sense for the firm in the high-tax jurisdiction to overpay for the goods and services rendered in order to reduce the total tax burden of the firm. On a consolidated basis, the maneuver just takes money out of one pocket and puts it into the other. The prices in effect move economic profits that should be assigned to the high-tax jurisdiction into the low-tax jurisdiction, resulting in net tax savings. Vestager is right to note that these disguised transfer payments constitute the kind of government subsidy that is prohibited under the EU. There is thus a clear conceptual warrant for her enforcement stance.

One common sense concern with Vestager’s position is that it leads to systematically higher taxes across the EU.

But it is at just this point that the analysis becomes more complex. In the usual case, it is the state government that is on the lookout for transfer pricing that short-changes its tax revenues. But this case breaks the mold, for the local governments are all too eager to make the transfers in order to attract the business. One common sense concern with Vestager’s position is that it leads to systematically higher taxes across the EU. That demand is consistent with the general EU preoccupation with “harmonization” across national boundaries, which in most cases leads to “harmonization up,” not down, and to bigger, not smaller, government. This move seems out of whack to classical liberals like myself who think that competition between jurisdictions is an effective way to lower overall tax burdens, which in turn should be able to increase overall economic efficiency. Put otherwise, one way in which to stop the transfer pricing problem is for other nations to lower their tax burdens so that they can compete with the current group of tax havens.

That logic does not sit well with Vestager, whose bellicose message is that competitive balance is best restored by forcing low-tax jurisdictions to turn into high-tax jurisdictions. The task, however, is not nearly as easy as it seems. As Vestager constantly notes, the Commission had to mount an exhaustive investigation to uncover the irregularities in transfer pricing which could not be justified by the underlying economic realities. But unpacking transfer price does not get any easier when virtually any and all business arrangements are subject to an investigation that might or might not turn up violations.

No one can be sure how this high stakes game will play out, but a transformation this large could easily go astray.

In this regard, it is one thing for her to say that her analysis shows that Fiat’s “taxable profits in Luxembourg would have been 20 times higher if the calculations had been done at market conditions.” But it is quite another to prove it against determined opposition, which could fight on both the existence, and more critically, the amount of the supposed surplus. The situation gets no easier if many of these subsidies are embedded in tax treaties of long-standing, or if the transfer pricing found in a single transaction loses significance when placed in the context of other pricing decisions. Imposing large taxes covering many past years of business could produce large unanticipated losses that could play havoc with current economic performance and future expansion plans. No one can be sure how this high stakes game will play out, but a transformation this large could easily go astray.

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In order to make her campaign go global, Vestager wants to place all EU countries under her microscope. As she candidly notes, the discharge of her mission will require companies suspected of “receiving state support, and their competitors, to hand over information relevant to our inquiries.”

There are massive dangers of Commission abuse in ramping up an investigation of this magnitude.

The proposition is ironic in two ways. First, there is in this connection scant regard for the issue of data privacy, which so exercised the European Court of Justice in its bombshell ruling that it blocks the shipment of data into the United States out of fear that it fall into the hands of the National Security Agency. But in this instance, the Commission offers no protection for data that is taken. Indeed like other big government activities, its major concern is that privacy issues could slow down its march to ever larger government. Nor does it offer any explanation to the innocent competitors who also will be required, presumably at their own expense, to turn this information over to the EU.

Second, there are massive dangers of Commission abuse in ramping up an investigation of this magnitude, especially in the absence of any statement of how market rate transfer price should take place. Nor is there any reason, I think, for the EU to take on this heavy burden.

Recall that any transfer pricing scheme necessarily reduces the tax revenue of those states whose firms do business with firms in the tax havens. It seems, therefore, that these states should have strong incentives to protect their own revenue base by launching their own investigation that would allow them to claw back any taxes lost. Using this method reduces the dangers of abuses of power at the center, and makes it harder forthe Commission to use its selective powers of investigation to target certain firms for investigation — firms like Google, with whom the Commission is sparring over issues of competition law as well. Vestager’s mission has to be evaluated on both means and ends. It may pass muster on the ends stated. But it does far less well in its choice of means.

Richard A. Epstein is the Laurence A. Tisch professor of law at New York University, the Peter and Kirsten Bedford senior fellow at the Hoover Institution at Stanford University, and the James Parker Hall distinguished service professor emeritus and senior lecturer at the University of Chicago.

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George Thomas

A highly subjective article – to say the least!

Posted on 10/24/15 | 8:59 AM CET

Alan Ritchie

.. no more subjective than Vestager’s opinion….

Posted on 10/24/15 | 11:45 AM CET

Gianluca Papa

The article is full of logical fallacies. Tax competition should be done in terms of tax rates, as also the author reminds, but not by choosing not to enforce transfer pricing rules. This way multinational companies would have all the benefits and no costs: they could choose to set up valuable economic activities (like R&D) in high tax countries because of some advantages they may have there (e.g. a more qualified labour force, better infrastructure and legal protection) and not paying the bill because they can shift profits to low tax jurisdictions where they set up paper companies. The European Commission simply tries to re-establish a level-playing field between operators in high-tax countries. Of course this it’s not the best solution but it’s a second best in those cases where Member States have chosen not to actively defend their tax base. An example is Ireland, where, thanks to the well-known loopholes, multinationals were not paying even the low tax rate applicable in Ireland (12.5%) having a level of taxation close to zero. This was done just to attract companies in the country in order to create jobs but renouncing to almost all taxation of profits. Also, the concern about privacy and information needs is outdated: the OECD has just published new guidelines for corporate taxation in the BEPS Action Plan, requiring an exchange between tax-authorities of detailed country-by-country reporting and transfer pricing documentation that must be provided by multinational companies.